Most Will Face a Rare Tax Increase With or Without ‘Fiscal Cliff’ Resolution

Americans are all but certain to face a broad increase in taxes today for the first time in at least two decades, ending a prolonged period of declining taxation that has become a defining characteristic of the American economy.

Regardless of whether President Obama and Congress reach an agreement to avoid the “fiscal cliff,” many Americans will see a higher tax bill because of the expiration of the payroll tax cut, which was enacted in 2011 as a temporary measure to boost economic growth. The tax holiday was preceded by a similar temporary cut in 2009 and 2010.

Lawmakers yesterday morning were locked in negotiations trying to close a deal that would, in part, prevent a separate tax – the income tax – from rising for all but the wealthiest taxpayers.

Unlike income taxes, which rise along with a worker’s income, the payroll tax is a fixed percentage of an employee’s salary. Allowing the tax cut to expire will increase taxes on salaries by 2 percent for every American worker. Up to $110,100 a year in salary is subject to the tax.

This jump in payroll taxes, combined with other tax increases affecting the very wealthy likely to take effect in the new year, would make for the largest increase in taxes in about half a century.

While the end of the payroll tax holiday appears to be a near certainty, Democrats and Republicans agree in principle that low tax rates enacted under President George W. Bush should be extended for the vast majority of Americans – with negotiations over the exact threshold ongoing early yesterday. If lawmakers fail to pass a law extending those tax cuts, allowing them to expire today, it would mean thousands of dollars out of the pockets of average workers, the largest tax increase on Americans since World War II.

But if lawmakers seal a deal to extend Bush-era tax cuts for most Americans, the payroll tax cut expiry is the only tax increase that most workers would experience. Higher-income earners would face steeper income taxes and potentially fewer tax breaks, as well as a new tax to pay for the Affordable Care Act health-care legislation.

Because of the expiry of the payroll tax cut, a worker earning $50,000, for instance, would pay $1,000 more in taxes next year; meanwhile, a worker earning less than $20,000 a year would pay about $100 more in taxes. Someone in the upper fifth of households, making $150,000 a year, will pay about $2,200 more.

The increase in taxes on workers next year means that “the era of asymmetrical tax policy – where taxes can only go down – is over,” said Jared Bernstein, a former White House economic adviser. “What’s been weird is in this history of taxation in America, there’s been this long period when it’s been forbidden to increase taxes at all.”

While the Obama administration fought for the payroll tax cut in previous years to goose a weak economic recovery, the White House has been more ambivalent this year. Before the election, even as prominent Democratic economists and lawmakers argued in favor of extending the tax cut, the White House declined to call for its renewal.

Then, during its post-election talks with congressional Republicans, the Obama administration requested an extension. But Republican lawmakers were skeptical, viewing the payroll tax holiday as contributing to federal deficits because the Treasury had to borrow money to replace payroll tax revenue, which ordinarily would go to fund Social Security. The administration quickly dropped the payroll tax cut from negotiations.

“I know for a fact that the White House economists think about it much the same way I do – as a very important part of stimulus in 2013 – but I think they just judged they couldn’t get it,” said Bernstein, who served as a top adviser to Vice President Joe Biden.

The tax increases will come after a period of tax cutting that began in 1997. That year, President Bill Clinton trimmed rates on investment income. President George W. Bush cut a wide range of taxes in six of his eight years in office, first as a response to projected budget surpluses and later in an effort to stimulate the economy.

President Obama continued the trend, cutting taxes in 2009 and then even more deeply in 2011, largely in response to the deep recession.

As a result, nearly half of American workers likely have never experienced a tax increase.

“We haven’t seen broad-based individual tax increases at the federal level in the last 30 years,” said Owen Zidar, an economist at the University of California. “In the 1960s through the 1980s, payroll tax increases affected most taxpayers, but the vast majority of broad-based tax changes have been cuts rather than increases.”

When considered as a percentage of the size of the nation’s overall economy, the tax increase set to occur today is likely to be the largest in about 50 years, according to a study of previous tax policy changes by Jerry Tempalski, a tax analyst in the Treasury Department.

Payroll taxes last went up in 1988, when they increased by 0.72 percentage points.

Some very small tax increases have taken effect in recent years, including an increase in taxes on cigarettes to pay for expanded health care for children and a tax on tanning salons to pay for Obama’s health care plan. Clinton increased taxes in 1993, but that mainly affected the wealthy. (By contrast, state and local taxes have been increasing over the years, in part to make up for budget shortfalls caused by the recession.)

Not only will middle class Americans be wrestling with higher taxes next year, they will be earning less income than they did just four years ago.

“Many more households are living paycheck-to-paycheck than just a few years ago given the very tough economy and the decline in real incomes. This amplifies the negative fallout from the expiration of the payroll tax holiday,” said Mark Zandi, an economist with Moody’s Analytics. “The still very weak consumer confidence, due in part to lower real incomes, also reinforces the negative impact of the end of the holiday.”

Economists say the expiry of the tax cut will be a major drag on the economy next year. Estimates suggest it could cost between 500,000 and 1 million jobs, leaving the unemployment about 0.4 percentage points higher than it otherwise would be.

Tax increases on the wealthy, by contrast, are expected to have much less of an effect on the economy.